by Edward I. Altman
(TMA International Headquarters)
Forty years ago, the author published an article in which fundamental financial data and equity market values were combined to effectively predict whether companies would go bankrupt in the U.S. The resulting Z-Score is a venerable financial tool that is still used to assess the creditworthiness of manufacturing companies throughout the world.
It also is still used frequently in credit and debt analysis, investment decisions, default probability, merger and acquisition screens, audit-risk, receivable management, and even by advisors and managers to manage financial turnarounds of distressed companies.1
This article extends the applicability of bankruptcy prediction to a unique assessment of the health of corporate industrial entities as they emerge from the Chapter 11 bankruptcy process and assesses the likelihood that a debtor will have to file for bankruptcy again — the so-called Chapter 22 phenomenon.
Over the years, in addition to the assessment of the overall effectiveness of the U.S. Chapter 11 bankruptcy process, there has been a fairly continuous debate over whether the process provides the right balance between reorganizing economically viable companies versus liquidating nonviable companies under Chapter 7. For companies that attempt reorganization, seeking temporary protection from creditors while putting in place an operational plan and financial structure that will permit them to emerge as going concerns, there are several ways in which one might evaluate the success of the reorganization.
The first requirement of a successful restructuring is that the company, in fact, emerges from the process as a going concern. A further test is to assess the post-bankruptcy results of the entity in terms of its operating and/or stock market performance. While this performance may be compared to other companies in the same industry or to some stock market index over time, it is clear that if a firm is forced to seek another distressed restructuring within a relatively short period of time after emerging, the process was not a success at all. The most extreme instance of a failed Chapter 11 is that the firm files for bankruptcy again — a situation that has been described as Chapter 22.2
Studies of post-bankruptcy performance find that while many companies restructure without the need of further remedial action, a striking number require that the reorganized business needs to restructure again through a private workout or a second — or even a third — bankruptcy.
For example, one study found that 32 percent of a sample of large companies that emerged as public entities restructured again through a private or court determined restructuring.3 Another that involved larger Chapter 11 filings found that 32 percent filed again within four years of emerging.4 While some companies emerge with too much debt, most cite operating problems as the primary reason for their second filing.
The troubling incidence of subsequent failures has accrued despite requirements under the Bankruptcy Code enacted in 1978 and amended in 2005 through the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA) that for a reorganization plan to be confirmed, the Bankruptcy Court must make an independent finding that the plan is feasible and that further reorganization is not likely or needed — specifically, that the plan “is not likely to be followed by the liquidation or the need for further financial reorganization of the debtor or any successors of the debtor under the plan” (Bankruptcy Code Section 1129(a)(11)).
In reality, however, unless there is convincing opposition from interested parties, the Bankruptcy Court has little choice but to sanction the plan as presented. Since most advisors and relevant stakeholders are biased toward emerging as soon as possible, opposition is fairly rare.
Historical Perspective
The purpose of the authors’ study was not to debate the merits of Chapter 11 but to analyze whether one could predict, with a reasonable degree of accuracy, which companies emerging from bankruptcy are more likely to suffer subsequent problems and file Chapter 22. In other words, can advisors, analysts, investors, and the debtors — indeed, the court system itself — avoid as much as possible the Chapter 22 phenomenon?
A relatively high proportion of larger companies that attempt to reorganize under Chapter 11 emerge as independent going concerns.5 At the same time, one study showed that for public companies of all sizes, only between 26 and 45 percent each year from 1990 to 2002 emerged with their reorganization plans confirmed by the courts.6 These statistics include many companies with multiple filings for various of their subsidiaries.
For companies with confirmed plans, about 44 percent emerged as publicly registered companies.7 The most important determinant of a company’s likelihood of emerging successfully was the firm’s size as measured by assets at the time of the bankruptcy petition and, more recently, by its ability to secure debtor-in-possession (DIP) financing.8 Not surprisingly, size and access to post-petition financing are highly correlated.
One study found that leverage remained high after both out-of-court restructuring and Chapter 11 reorganization, although it remained considerably more elevated after the out-of-court strategy.9 In a study of 58 out-of-court cases and 51 companies that went through the Chapter 11 process from 1980 to 1989, the median ratio of long-term debt (face value) to the sum of long-term debt and common shareholders’ equity (market value) was 0.64 for companies that restructured out-of-court and 0.47 for those that reorganized in Chapter 11.
Hence, significant remaining debt on the balance sheets of reorganized companies could contribute to their re-filing in the not-too-distant future after emergence. The study also found that as much as 25 percent of the total sample had to file for bankruptcy (again, in the case of emerged companies from Chapter 11) or restructure their debt again.
Another study found similar results in that while companies they studied substantially reduced their debt burdens in “fresh start” Chapter 11 reorganizations, they still emerged with higher debt ratios than what is typical in their respective industries.10 The researchers studied 172 companies that emerged from Chapter 11 under “fresh start” accounting values (companies that emerged with a significant change in equity ownership) from 1990 to 2004.
A number of studies have examined the post-bankruptcy performance of public companies. Several assessed the performance of companies’ profitability and cash flows relative to comparable companies in similar industries. More than two-thirds of emerged companies underperformed industry peers for up to five years following bankruptcy and, in some studies, as much as 40 percent continued to experience operating losses in the three years after emergence.
On the other hand, recent experience for larger companies has shown improved post-bankruptcy experience. One study showed significant excess stock market returns in the 200 days following emergence for companies that emerged from 1980 to 1993 with publicly listed equity.11 While this positive stock price performance seems to be cyclical, with poorer performance in the mid- to late 1990s, a number of companies more recently enjoyed spectacular post-bankruptcy returns after the surge in bankruptcies in 2001 to 2002.12
Another study found that investing in formerly bankrupt companies’ equities between 1988 and 2003 (sample of 111 companies) resulted in a positive average 85 percent relative to the Standard and Poor’s (S&P) 500 Index performance in the first 12 months after emergence.13 The volatility of these returns was extremely high, however, with only 50 percent of the stocks outperforming.
A few additional studies showed fairly positive post-bankruptcy performance or at least less negative experience. One examined a sample of 89 companies emerging from bankruptcy between 1983 and 1993 and computed the five-year annualized return earned by the reorganized company, relative to the value that would have been received in liquidation and invested in alternative assets.14 The researchers found that the reorganized companies’ annualized returns did not differ significantly from returns for the S&P 500 stock index — that is, they neither under- nor overperformed.
From a sample of 288 companies that defaulted on public debt — most of which went bankrupt — another study found that while 32 percent experienced negative operating performance in the year following emergence if no outside “vulture” investors with significant ownership were directly involved, only about 12 percent had the same negative experience when a vulture was actively involved in the company’s restructuring.15
Adapting the Z-Score
As noted earlier, roughly one-third of companies emerging as publicly registered companies experience some form of subsequent distressed restructuring, including the filing of a second (or third, or even more) bankruptcy.16 Figure 1 shows the number of Chapter 22s and Chapter 33s from 1984 to 2009. Including 19 in 2008 (the highest single-year total in the authors’ sample) and 12 in the first six months of 2009, there have been 209 Chapter 22s and nine Chapter 33s.17
In a sample of about 75 Chapter 22s that the authors observed, the second filing for each company took place within nine years of the firm’s emergence from its first Chapter 11, and a surprisingly large proportion — 89 percent — occurred within five years of emergence.
For example, for Chapter 22s filed in 2008 and 2009, 21 of 32 filed again within five years and 23 of 31 within six years. In 2008, the average time between the first emergence and the second filing was four years, six months (three years, nine months median).
Usually, but not always, the amount of assets of Chapter 22 companies is greater at the time of the first filing than at the second, because one of the strategies used in most bankruptcy reorganizations is the sale of assets to improve operations or to provide needed liquidity. For example, in 24 of the 31 Chapter 22s in 2008 and 2009, the second bankruptcy had lower assets than the first.
It is quite interesting to observe that Chapter 22 instances were still prominent in 2008 and 2009, despite the fact that the outright sale of the bankrupt company during the bankruptcy reorganization period is increasingly common under BAPCPA. Time will tell if the Chapter 22 phenomenon will decrease somewhat as the older reorganizations are flushed from the system.
What the authors are observing of late, however, is that many of the larger bankruptcy filings involve prepackaged agreements, which usually only attempt to fix a distressed company’s capital structure problems. Among these cases, more Chapter 22s might be expected.
To assess the ability to predict the subsequent performance of companies emerging from Chapter 11, the authors used a bankruptcy prediction model known as the Z”-Score model, patterned after the classic Altman Z-Score model of 1968. The Z”-Score model was first developed for testing the efficacy of credit scoring of emerging market companies18 and then applied to U.S. non-manufacturers, as well as manufacturing industrials.
The logic behind this methodology is that if a model has proven to be credible and accepted by academics and practitioners for predicting corporate distress,19 it might also be effective in assessing the future health of companies emerging from bankruptcy reorganization, especially if the result one is trying to predict (and avoid) is a second bankruptcy filing.
The original Z-Score model applied primarily to publicly held manufacturing companies, although many use it for other industrial companies as well. (The model applies to publicly held companies because one of the variables, the market value of equity/total liabilities, requires the availability of publicly traded equity.) To make the model more robust across all industrial groupings, as well as for privately owned companies, Altman developed the Z-Score model, first for U.S. companies and then adapted for emerging market companies (Figure 2). The Z”-Score model has four variables, not five as in the original model. The sales/total tangible assets variable is removed and the coefficients re-estimated.
To make the model more meaningful, Altman developed the concept of a bond-rating-equivalent (BRE) of the Z”-Score (and for Z-Score as well) (Figure 3). The equation used to calculate Z”-Score was modified by adding a constant term of 3.25 to scale the scores to a D rating equal to zero (0.0).20 Companies with Z”-Scores above zero have BREs in the non-bankrupt zones (AAA to CCC-).
The authors applied the Z”-Score model to two samples of companies that emerged from bankruptcy. One consisted of Chapter 22s or 33s, companies that filed for bankruptcy a second or third time. The second sample represented Chapter 11 emergences that did not file a second time.
Because both samples represented companies that had undergone extensive restructuring, usually involving both operations and capital structure, one might expect that their financial profiles upon emergence would resemble those of a going concern, non-bankrupt entity. If, however, the bankruptcy prediction model were effective in detecting future problems, the average Z”-Score values of the Chapter 22 sample should be significantly lower (worse) than the sample of Chapter 11s.
Sample Characteristics
The effective confirmation dates of the bankruptcy reorganization plans for the 45 Chapter 11s in the sample was between 1993 and 2003. The latter date was chosen so that at least five years had elapsed since the firm emerged from bankruptcy without filing again. The companies were chosen based mainly on data availability for calculating the Z”-Score distress prediction model.
The objective was to assemble a reasonably large representative sample of industrial companies that filed for bankruptcy under Chapter 11 and emerged as publicly held companies with post-bankruptcy financial data available during roughly the same data period as that for the Chapter 22 sample.
The size of this sample was similar to the Chapter 22 sample. The data source for emerged companies was New Generation Research, whose database goes back to 1993.21 While the authors did not match the two samples exactly by year of emergence, the distribution by emergence year was quite similar, with the exception of companies emerging in 2003, when there were 11 Chapter 11s and only two Chapter 22s.22
For the 41 Chapter 22 companies, the effective emergence date from their first bankruptcy ranged between 1993 and 2006 (only two were after 2003). Five of the companies were Chapter 33s, so they appeared twice in the sample. The average time between the effective emergence date and the second filing date was three years, 41/2 months. The range of the durations from the emergence to the second filing date was between one year, 10 months, and eight years, eight months.
While the number of Chapter 22s sampled was about 30 percent of the total Chapter 22s since 1993, they represented a broad cross-section of industrial companies and virtually all entities for which the complete financial data required to calculate the distress prediction model could be obtained. Likewise, the 45-firm sample of Chapter 11s represented a broad cross-section of non-second-filers.
To test the effectiveness of screening Chapter 11 emerging companies for potential serious subsequent distress, the Z”-Score model was applied to the samples of Chapter 11 single versus multiple filers. A comparison of the average Z”-Scores and their respective bond rating equivalents (BREs) was observed, and statistical difference tests were applied between the two groups.
The average Z”-Score for the sample of single filers (Chapter 11s), based on data from their first financial statement following emergence, was 4.73 (4.38 median), with a bond rating equivalent of B+. This is consistent with observations over time that almost all companies that emerge with bonds outstanding have bond ratings in the B to BB range, rarely higher.
For the Chapter 22 sample, the average Z”-Score was considerably worse, at 2.67 (3.05 median), with a BRE of CCC. The differential between the average Chapter 11 and Chapter 22 Z”-Scores remained similar based on data from an additional year beyond the emergence date (4.65 vs. 2.45). Indeed, the Chapter 22s’ average scores dipped by 0.08 one year after the first financial period, consistent with deteriorating conditions as the company moved toward its second filing.
For the sample of Chapter 22s, nine of the 41 companies actually had a financial profile (BRE) at a point nearest the emergence date consistent with a D (default) rating, and only 16 had BREs better than CCC. Most of these companies showed unmistakable early warning signals of future distress. For the 45-firm Chapter 11 sample, only one company had a Z”-Score consistent with a D profile bond rating equivalent.
To test the statistical significance of the average results of the two samples of Chapter 11 emerging companies, the authors performed a “difference of means” test (Figure 4). The t-test between a mean of 4.73 (Chapter 11s) and 2.67 (Chapter 22s) was significantly different at the 0.01 level (t-test = 3.84) at the point nearest the emergence date and also one year later (t = 3.60).
So, it is clear that the sample of companies that eventually filed a second bankruptcy petition had significantly worse financial profiles just after emerging from bankruptcy than did the sample of companies that remained going concerns for at least five years after emerging.
Why Restructurings Fail
The study shows quite clearly that the overall risk profile of companies that unsuccessfully reorganize under Chapter 11 look considerably worse than those that manage to emerge and remain as going concerns. The authors then wanted to observe, if possible, whether there were specific signals in addition to the composite Z”-Score criterion of the impending fate of these two groups. To accomplish this, the authors analyzed the Z”-Score model’s four individual indicators, which represent indicators of corporate liquidity, solvency, profitability, and leverage. The results are quite revealing.
Figure 5 lists the means, standard errors, and the difference in means test between the two main samples of Chapter 11 versus Chapter 22 companies for the four explanatory variables in the Z”-Score model. The authors concluded that the Chapter 22 sample had inferior measures in all four dimensions. In particular, measures of profitability and leverage were statistically significantly different between the two groups.
While it could be argued that a reorganization plan eventually could lead to improved profitability, there does not appear to be any excuse for the overleveraged situation. Indeed, the equity-to-total liability ratio of Chapter 22 companies was only 0.27 versus 0.74 for the Chapter 11 companies. To put it differently, the leverage of companies that failed again was almost three times greater than those that emerged and remained solvent.
The Chapter 22 sample had almost four times as much in liabilities as equity ($3.70 of debt to every $1 of equity), while the Chapter 11 companies had about $1.35 of debt to every $1 of equity. The prescription for future successful reorganizations is clear — the balance sheets of emerging companies should not be loaded with excessive debt.
Implications, Conclusions
The authors’ study examined the financial profiles of companies emerging from the Chapter 11 bankruptcy process as publicly registered and owned companies. Using the Z”-Score distress prediction model, they found that companies that filed a subsequent bankruptcy petition had significantly worse financial profiles than did a sample of companies that emerged as going concerns and continued in that condition.
Indeed, the average financial profile and BRE for a company from the Chapter 22 sample when it emerged from its first bankruptcy was not that much better than that of a defaulted firm. Companies that filed for bankruptcy a second time emerged as significantly less profitable with significantly more leverage than those that emerged and remained as going concerns.
The authors believe that a credible corporate distress prediction model can be an important indicator of the future success of companies emerging from bankruptcy and could even be used as an independent “advisor” by U.S. Bankruptcy Courts to assess the future viability of a reorganization plan, which, as the code stipulates, should be done. It also could be used by those responsible for devising and/or assessing a reorganization plan with the possible positive benefit of further modifications if an emerging company’s profile mirrored those of a continuing distressed company.
Another potential benefit is for creditors of the “old” company to assess the investment values of the new package of securities offered in the plan, including new equity. Or, for those investors considering purchasing the new equity, the technique can be another analytical tool. Finally, professional turnaround specialists who might be involved in these cases can use this early warning technique to assess the likelihood that their efforts will succeed.
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1 For a more detailed description of Z-Score applications, see Edward I. Altman and Edith Hotchkiss, Corporate Financial Distress & Bankruptcy. 3rd edition. John Wiley (2006).
2 Edith Hotchkiss, working on her dissertation at the Stern School of Business, New York University, compiled a list of “two-time filers,” which we called Chapter 22s. Among the early two-time filers of Chapter 11 were Commonwealth Oil (1979, 1984), Cook United (1984, 1987), CS Group (1982, 1984), W & J Sloan (1981, 1988) and Continental Airlines (1983, 1999).
3 Edith S. Hotchkiss, “Postbankruptcy Performance and Management Turnover.” Journal of Finance 50: 3 (1995).
4 Lynn M. LoPucki and William C. Whitford, “Patterns in the Bankruptcy Reorganization of Large, Publicly Held Companies.” Cornell Law Review 78: 597 (1993).
5 This proportion is expected to shrink in the current credit market crisis due to the difficulty in attracting lenders to provide adequate DIP loans just after filing and sufficient exit financing to enable emergence. Hence, the incidence of Chapter 7 liquidations is likely to increase.
6 Altman and Hotchkiss (2006).
7 Edith S. Hotchkiss and Robert Mooradian, “Post-Bankruptcy Performance: Evidence from 25 Years of Chapter 11,” Working Paper. Boston College and Northeastern University (2004). The study involved 1,400 Chapter 11 case outcomes from 1979 to 2002.
8 Sandeep Dahiya, Kose John, Manju Puri, and Gabriel Ramirez, “Debtor-in-Possession Financing and Bankruptcy Resolution: Empirical Evidence.” Journal of Financial Economics 69. 1: 259 (2003).
9 Stuart Gilson, “Transactions Costs and Capital Structure Choice: Evidence from Financially Distressed Firms.” Journal of Finance 52: 161 (1997).
10 Randall Heron, Erik Lie, and Kimberly Rodgers, “Financial Restructuring in Fresh Start Chapter 11 Reorganizations,” Working Paper, Indiana University, October (2006).
11 Allan Eberhart, Reena Aggarwal, and Edward Altman, “The Equity Performance of Firms Emerging from Bankruptcy.” Journal of Finance 54: 1855 (1999).
12 The poster child for impressive returns was Kmart Inc., whose stock traded under $14 per share when the firm emerged in May 2003 but rose to almost $200 per share within 11/2 years. Other notable gainers of a more than 40 percent return in excess of the S&P 500 in the two years after emergence were American Commercial Lines, Atlas Air Holdings, Chiquita Brands International, Dade Bearings, Haynes International, Sears Holdings, Laidlaw International, Leap Wireless, McLeod USA, Motient Corp., MPower, NRG Energy, Petroleum Gas Services, Spectra Science, Texas Petroleum, Warnaco Group, and Washington Group International.
13 J. Thomas Lee, and John Cunney, “The Chapter After Chapter 11.” New York: J.P.Morgan (2004).
14 Michael Alderson and Brian L. Betker, “Assessing Postbankruptcy Performance: An Analysis of Reorganized Firms’ Cash Flows.” Financial Management 28:68 (1999).
15 Edith S. Hotchkiss and Robert Mooradian, “Vulture Investors and the Market for Control of Distressed Firms.” Journal of Financial Economics 43: 401 (1997).
16 Amazingly, one company, Trans Texas Gas Corporation, whose initial filing was prior to the 1978 Bankruptcy Reform Act, has filed and emerged four times. Following its most recent emergence in 2003, it operates as a private company. In addition, four of Donald Trump’s various hotel and entertainment enterprises have filed for bankruptcy (in 1982, 2001, 2004, and 2009). They were included in the Chapter 22 sample because the specific properties involved are different.
17 Two recent seeming Chapter 33s, Frontier Airlines (2008) and National Energy Group (NEG) (2003), were actually two distinctly different companies, and so they were not included as Chapter 33s.
18 Edward I. Altman, John Hartzell, and Matthew Peck, “Emerging Markets Corporate Bonds: A Scoring System,” Salomon Brothers (1995) and 1997 in The Future of Emerging Market Flows. ed. By R. Levich. Klumer.
19 The Altman Z-Score models are widely accepted and found in financial textbooks and scholarly articles, as well as on many financial software packages and information sources. For example, Bloomberg terminal results show that there are regularly close to 1,000 “hits” per day on the “Altman Z-Score” (AZS) page.
20 The average Z”-Score of a sample of companies filing for bankruptcy prior to 1996 was -3.25; hence, the addition of that constant term.
21 Three Chapter 22 companies that emerged just prior to 1993 (1991 and 1992) are included.
22 This was done to increase the sample of Chapter 11s. If the authors had randomly selected only seven Chapter 11s in 2003 to make the size of the two samples exactly the same (41), the comparative results would have been almost identical to that of the slightly larger sample.